St. Martha

Why Martha Stewart should go to heaven and the SEC should go to hell.

Michael McMenamin from the October 2003 issue

(Page 3 of 4)

The U.S. Court of Appeals for the District of Columbia Circuit upheld the SEC's action. In a decision that can charitably be described as confused, the D.C. Circuit ruled that the Supreme Court really did not mean what it said in Chiarella. Even though Dirks had no fiduciary responsibility to Equity Funding, the appeals court said, he had an overriding obligation to the SEC and the trading public to disclose the fraud or to refrain from trading.

The Supreme Court, which ruled on Dirks' appeal in 1983, was not pleased. In unusually blunt language, Justice Powell wrote: "We were explicit in Chiarella in saying that there can be no duty to disclose where the person who had traded on inside information was not [the corporation's] agent...was not a fiduciary, [and] was not a person in whom the sellers [of the securities] had placed their trust and confidence."

The Supreme Court's message to the SEC in Dirks was as clear as it was in Chiarella: If you want a level playing field, go see Congress, not us. Section 10(b) is about fraud, not fairness. The Court also went out of its way to chastise the SEC for its inconsistency in insider trading enforcement. Suggesting that it was "hazardous" to deal with the SEC, the Court accused the commission of bringing "test cases" that contradicted its stated enforcement policies. In his opinion, Powell quoted from a speech by a former SEC chairman who said the commission "does not contemplate suing everyone who may have come across inside information" and specifically listed as people who would not be sued "persons outside the company such as the analyst or reporter who learns of inside information" -- in other words, people like Ray Dirks.

Misappropriated Logic

When Powell retired from the Supreme Court, the SEC got the opportunity to try out a new version of the level playing field theory based on the concept of "misappropriation." It's best illustrated by Wall Street Journal reporter Foster Winans, who was one of the writers of the Journal's "Heard on the Street" columns, which frequently affected stock prices. Perhaps comforted by that SEC chairman's assurances that reporters wouldn't be sued, Winans agreed to disclose the subject of the next day's column to a broker who sometimes traded on that information, giving Winans a small portion of his profit.

Like Chiarella, Winans was hit with both civil and criminal charges even though he had no fiduciary obligations to either the buyers or the sellers of the stocks traded. The only party he defrauded was his employer, The Wall Street Journal (which fired him but did not pursue criminal charges). The only basis for the insider trading charges against Winans was the level playing field theory, i.e., the idea that selling advance information about the column wasn't "fair" to the market. Yet the SEC argued that because he had committed a fraud on his employer, The Wall Street Journal, by "misappropriating" information that belonged to it, Winans was guilty of securities fraud under Section 10(b), even though the entity he defrauded, The Wall Street Journal, had no connection with any securities trade. Winans was convicted of insider trading as well as federal mail and wire fraud, and the 2nd Circuit upheld his conviction. The Supreme Court affirmed Winans' mail and wire fraud conviction but split 4�4 on the insider trading conviction and issued no opinion. Powell, who had retired a few months earlier, would have been the deciding vote.

It wasn't until 1997, in United States v. O'Hagan, that the Supreme Court approved the misappropriation theory. O'Hagan was a lawyer whose firm represented a company that intended to make a tender offer for Pillsbury. O'Hagan "misappropriated" this information without his client's knowledge or consent by buying call options in Pillsbury stock, which became very valuable when the tender offer was announced. O'Hagan took home a tidy $4.3 million in profits. As with Chiarella, Dirks, and Winans, no one in the market was hurt by this action, not even O'Hagan's client. The government, under the same misappropriation theory it had used with Winans, secured a conviction. The U.S. Court of Appeals for the 8th Circuit reversed on the grounds that the misappropriation theory was beyond the scope of Rule 10(b)(5) and did not involve fraud directed toward a buyer or seller of securities. The 8th Circuit also reversed O'Hagan's mail fraud and money laundering convictions, concluding that they rested on violations of the securities laws that had not been proven.

There was no way the Supreme Court could let a lawyer get away with making millions of dollars by stealing confidential client information, so it reinstated the conviction and approved the misappropriation theory. But the Court said its decision was not based on fairness or protecting the trading public. The Court in its decision and the government in oral argument agreed that it would have been perfectly legal for O'Hagan or Foster Winans to trade on their inside information had they privately disclosed to their client and employer, respectively, what they were doing, notwithstanding the "unfairness" to the market. No deception, no foul.

Although the misappropriation theory narrows the definition of insider trading, the SEC continues to believe in the level playing field and to look for ways to broaden its approach. In O'Hagan the government argued that "the very aim of [section 10(b)(5)] was to pick up unforeseen, cunning, deceptive devices that people might cleverly use in the securities markets." Justice Clarence Thomas quoted this claim in his dissent, along with the dry response of one of his colleagues: "That's rather unusual for a criminal statute to be that open-ended, isn't it?" Yes, it is. But open-endedness has its advantages. It allows the SEC to ignore, condone, or even facilitate insider trading when it chooses and then go after a juicy target like Martha Stewart, whose alleged insider trading is well outside anything recognized as such by the Supreme Court.

Ivan the Not-So-Terrible

In its heart of hearts, even the SEC knows insider trading doesn't hurt the market. Remember the financier Ivan Boesky? Back in the 1980s, Boesky agreed to pay a record $100 million in penalties for trading on inside information purchased from the Drexel Burnham Lambert investment banker Dennis Levine. The Wall Street Journal estimated that Boesky had made more than $200 million in profit from Levine's information. By cutting a deal, the SEC let Boesky keep half of his illicit profits.

But wait, it gets better. Before the SEC announced the settlement, it allowed Boesky to cut his trading partnership's liabilities by $1.3 billion through a series of government-sanctioned insider trades. SEC Chairman John Shad later told a House committee that the market wasn't hurt by those trades because it bounced back after a one-day loss. So keeping $100 million in ill-gotten gains and executing insider trades totaling more than $1 billion are both OK if the SEC says so.

Yet Martha Stewart got nailed for saving $45,000 without breaching a fiduciary duty to anyone. The initial trading case against her centered on whether she knew that Sam Waksal was selling his ImClone stock because of the FDA's impending rejection of the company's anti-cancer drug. The feds interviewed Stewart about the sale and claim that during the interview she lied to cover up her wrongdoing and then issued false claims of innocence when anonymous government sources leaked these unproven accusations against her, allegedly doing so to support her own company's stock price.

The government now admits Stewart never had inside information from Waksal. Here are the facts patched together from various pleadings and other public accounts:

On December 27, Stewart and her friend, Mariana Pasternak, were flying in Stewart's private jet to San Jose del Cabo, Mexico, for a vacation at a resort. The plane stopped to refuel in San Antonio, where Stewart called her office on her cell phone and learned that her Merrill Lynch broker (and friend), Peter Bacanovic, had telephoned. Bacanovic, who was also a broker for Waksal and his daughter, Aliza, was in Miami at the time and didn't connect with Stewart when she returned his call at Merrill.